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Since the end of June, global equity flows have been negative and F23 earnings estimates for the S&P 500 are down 7%, yet the index has rallied more than 11%. We chalk the move up to two things: lower discount rates and higher risk tolerance, at least on the part of some investors. Meanwhile, Treasury and bond markets are signalling risk-off. With the full effects of inflation and monetary tightening still to come, we remain on the side of caution, especially with the shifts we are seeing in company fundamentals ahead of second half earnings.
One crowd sees risks rising: In the search for safe havens, the yield on the U.S. 10-year has dropped 20 bps since the end of June, further inverting the yield curve and sending a clear signal of preparations for a recession.
Another is ready for more: Meanwhile, investors still in the market have bid down the earnings yield by 80 bps versus 10-year Treasuries. The combination of a lower 10-year yield and a lower risk premium has pushed the S&P earnings yield for F23 down to 5.2% from 6.2% at the end of June. For what it is worth, for the 10 years ended 2019, a 5.2% earnings yield represents a top decile result, while a 6.2% yield is only slightly above the median of 6.0%.
Analysts, of course, are still bullish: According to current estimates, S&P 500 earnings are expected to grow 10% year-over-year in 2023. For reference, from 2010 to 2019, index earnings grew at 6.8% annualized, with earnings growing by 10% or more in just 4 of the 9 years.
Yet even benign assumptions point downwards: If we assume 7% earnings growth on current F22 estimates of $197.33 and apply a 6.0% earnings yield premium, we arrive at 3,519 on the S&P 500, which is down about 16% from current levels.
In our view, the relief rally is premature: Higher growth estimates and very low earnings yields involve a lot of wishful thinking. Namely, one would have to believe:
- The U.S. Fed won’t raise rates aggressively through year end – even though its governors have repeatedly signalled otherwise.
- Inflation will come down without consumer spending and the economy slowing further.
- Earnings estimates for 2023 have put in a bottom – even though the effects of higher inflation, tighter labour markets and slower economic growth haven’t fully hit yet.
- Companies are pulling their second half guidance because of uncertainty and not because their management teams are already seeing results deteriorate.
Certainly, staying invested allows investors to participate in the current rally, however long it holds up. We nevertheless advise doing some work now to de-risk portfolios in preparation for tighter monetary conditions and the earnings headwinds ahead. That means sticking with stronger, cash-generating companies; capable management teams; and business models built to weather tougher economic environments.
To this end, we continue to benefit from the ideas generated by our affiliate Veritas Investment Research Corporation, which remains one of the best equity research shops on the street.
Year-to-date through July 29, 2022, the NASDAQ was down 20.5%, the S&P 500 was down 12.6% and the S&P/TSX was down 5.7%. Over the same period, our Canadian Equity Fund fell 2.9% and our Absolute Return Fund was 3.7% lower. (Performance based on F series).
We remain focused on capital preservation during the current market volatility while pursuing opportunistic investments to drive returns.